Economics 26/03/2010: National output figures

Held back by work, I am only now catching up with data released this week by CSO, so do stay tuned - these pages will be featuring more analysis in days to come.

First, QNA for Q4 2009 came in, putting annual decline in GDP at 7.1% for 2009 and GNP at a whooping 11.3% (per table below):
This is slightly better than my predicted annual declines of GDP to the tune of 7.3% and GNP to 11.5-11.7%. Nonetheless, as CSO admits, these figures mark historical record of declines.

Throughout the year, I have traced the paths for the main QNA series in charts. A picture, after all, is worth a thousand words. So here they are, updated for the latest figures:

The first chart above shows GDP and GNP time series. Two things are apparent from these figures: first, all three series peaked at the same time - in 2007. This is significant for as we shall see below, the same does not hold for growth rates. Second, notice how factor cost-based GDP is showing more mild downward trend than market prices-based GDP measure? This suggests that deflation (market prices change) has been so far much more significant than declines in factor costs. This does not really bode well for our hopes of improving our competitiveness through this cycle.

Next chart shows components of GDP and GNP:
Notice how two state-supported sectors - public sector and agriculture (the latter supported, of course, via CAP) show no signs of a recession? Both are having jolly good time - courtesy of taxpayers (Irish and European). Also, do keep in mind that some of the public sector activities fall into other categories - e.g. transport was probably supported by the semi-state companies and their ability to ignore recession when it comes to hiking prices and charges (DAA is one good example here). So in real terms, private sector activity in each one of these sub-sectors is down by more than the CSO aggregates suggest.

Next chart illustrates another historic record:
The gap between our MNCs-dominated exporting economy and our domestic economy is now at historic highs - reaching 23% in 2009. This means that almost a quarter of what Ireland claims to produce (GDP) is really an accountancy trick and has nothing to do with this country. Of course, for years we have been conditioned to think that we are filthy rich because our GDP is so high. Oh, how deep the fallacy runs.

Now, think about the core metrics of state solvency deployed in international markets. Take our national debt. At current €77.6bn (per NTMA) it officially stands at just 45.6% of our GDP (46.2% if we are to use more time-consistent estimate from Finance Dublin). In the real world, this figure should reflect our real national income, for we can't seriously expect the foreign MNCs to be responsible for Ireland's debt. So the real figure should be 55.5% of GNP. Almost a 10 percentage points spread.

Now, let's take our current position and take a peek into the future. Suppose we take last 6 years' average growth rates for respective series. How long will it take for our various measures of income (bogus GDP and more honest GNP) to bring us back to the prosperity of 2007?
As chart above illustrates, should our MNCs continue racing ahead as they did up until now, happy days will come back to our shores again in 2018. Of course, relying on our domestic (real) economy to chug along as it did in 2003-2009 period means we will be back to 2007 levels of income some time around 2026. Mister Cowen can keep telling us that things have bottomed out and that all will be well once growth returns. Numbers are a bit more honest here.

What else did the QNA release give us that CSO omitted in its release?

Let's take a look at quarterly frequency:
Notice how both GDP and GNP are running close to (but below) 4-quarter moving averages? This is the third time it is happening in the current crisis and every time it is followed by a renewed pull away from the MA line downward. GNP is seemingly poised to cross over in Q1 2010, posting a possible quarterly gain. Of course, this is just a momentum force, which has to be backed by fundamentals. And the fundamentals are still pretty nasty. But there isn't a hope of even a technical rebound indicated in the GDP line. So:

• Will we see a GDP/GNP gap contracting somewhat in Q1 2010 with GDP starting to show much more weakness than GNP?
• Will GNP loose technical momentum building up and renew its downward slide?

Only time will tell, but, here is an interesting snapshot. Remember the latest QNHS? Q4 2009 marked the return of Construction sector to the leading role in driving unemployment higher. This is collaborated by the following figure:
Activity in construction and building sector shows absolutely no willingness to move above the moving average line. If anything, it is still contracting at a massively rapid rate.

Lastly, let me show you an interesting chart on annual rates of change in the GDP/GNP series:
Notice that in contrast with levels in overall activity (the first chart above), growth rates actually peaked in two different years, with 2007 decline in the growth rate of GNP clearly providing a warning signal for the Government that things might be getting slightly unsteady. Coupled with what was going on at the time in the financial markets (remember, the crisis in financial markets started actually in July 2007), that was a warning shot. I recall interpreting it this way in a couple of my columns - back in Business & Finance and in the Sunday Tribune.

I will cover trade figures contained in QNA release in the later post dealing with overall trade issues, so do stay tuned.

Economics 23/03/2010: Re-shuffling yields no trump cards

Let us first outline the conditions under which today's reshuffle took place:

• Earlier today Friends First Quarterly Economic Outlook predicted that after falling 50% since 2007, house prices will decline by 10% more this year. So the total drop through the cycle expected by Friends First is around 55%.
  

If house prices grow at 3% on average per annum, it will take us until 2038 before we recover the nominal losses in the property prices. If we are to assume that the spread between asking price premium paid in 2007 and asking price discount available today is 7.5% (+/-5%), to will take us until 2044 to regain the peak prices levels in nominal terms.

If property prices grow at 1.5% in real terms per annum (comparable to what has been happening in the better performing developed markets around the world since the 1960s), we will be able to restore 2007 levels of real housing wealth only in 2078, using the +/-5% discount/premium spread, or 2064 if we just take asking prices.

The previous Cabinet, absent three exceptions, has presided over this boom and the bust. The re-shuffled one did as well. Is this a dramatic departure from the policies of the old?

• Second, also today, a report from PwC has forecast that the Irish economy will shrink by 1.3% this year, before returning to growth of around 1.8% in 2011. This means that peak to trough PWC expects economy to contract 12% in terms of GDP, and approximately 16.3% in terms of GNP. PWC forecasts that economy will return to growth of around 1.8% in 2011.
  

Assuming this will be the 'new normal' on average, it will take Ireland Inc until 2019 to regain the nominal levels of GDP we enjoyed at the peak of the bubble and until 2021 to do so in terms of domestic economy income.

I am not going to outline the rest of the bleak conditions that form the backdrop to today's cabinet reshuffle, but it was clear from the beginning that a significant change in the Cabinet was required if the country were to have any hope of change in policies.

Which brings us to the new Cabinet formation:

Below, I will marks Taoiseach's decision out of 5 points maximum possible corresponding to 'Excellent' with 0 corresponding to 'Extremely Poor'. These scores do not attempt to rate individual Ministers past performance, but rather the decision made by Taoiseach in making new appointments.

• Mary Coughlan - Tánaiste, Minister for Education and Science – No comment – the title says everything… 0/5
• Brian Lenihan - Minister for Finance – the best we can do in this Cabinet… 5/5
• Mary Harney - Minister for Health – the only person willing to take the poisoned chalice and run with it for 6 years… 5/5
• Noel Dempsey - Minister for Transport – a safer bet, despite a number of high profile errors (T2 contract to DAA, etc) and insistence on a number of White Elephants, e.g. Metro North – 3/5
• Dermot Ahern - Minister for Justice, Equality and Law Reform – a better candidate for an economics post, but a good call for his current post as well. Ahearn deserved a promotion by virtue of being a more promising senior and experienced figure for key post and in this environment. Economics posts are the key ones – 3/5
• Micheál Martin - Minister for Foreign Affairs – best suited for his current role - 5/5
• Éamon Ó Cuív - Minister for Social and Family Affairs – think ‘experience’ (though he did run Gaeltacht Affairs - a largely welfare scheme) - 0/5
• Mary Hanafin - Minister for Arts, Sport and Tourism – Mary Hanafin deserved a much greater role in the Cabinet, with good potential to run an economics portfolio, her placement in Arts, Sports and Tourism is an opportunity foregone, 0/5
• John Gormley - Minister for Environment, Heritage and Local Government – this is a purely political balancing act, 2/5
• Eamon Ryan - Minister for Communications, Energy and Natural Resources – see John Gormley, 2/5
• Brendan Smith - Minister for Agriculture, Fisheries and Food - a very significant portfolio especially when one recognizes the role of food exports in total indigenous exports– see Eamon O Cuiv above, 0/5
• Batt O'Keeffe - Minister for Enterprise, Trade and Innovation – possibly an interesting move, risky, but… Batt O’Keeffe did some honest, if strangely inconsistent work in DofE. His record, ranging from brave and intriguing to unexplainable, should be interesting to watch at DETI. But is this a ‘steady, strong hand’ that one needs to move things forward in the second most important department in the country? I simply do not know. So: 3/5.

Average score: 28/60 or 47%. It won’t earn one a pass in a post graduate programme course.

Now to the second test – the rearranging of the chairs floating over the spot where Titanic sunk:

• The Department of Enterprise and Trade is now to take responsibility for Innovation. And lose responsibility for Employment. Given that DETE used to be one of the more competent of all departments in the past, this clearly suggests that the Government has no real policy platform for combating unemployment. Score on decision: 0/5.
• The Department of Education is to become the Department of Education and Skills. DofE has no capability or experience in dealing with the matters of skills. VAC schemes that it runs are shambolic at the very best and never were benchmarked or tested properly. To acquire expertise it would need FAS, plus some Forfas capabilities, plus access to multinational and domestic employers. DofE - focused on the needs of secondary education sector since its foundation - simply cannot be expected to deploy an enterprise-centred culture needed to build them. Score on decision: 1/5.
• The Department of Social and Family Affairs will become the Department of Social Protection - it will take responsibility for FÁS. Which now puts our Government into a position of formally admitting that FAS ‘training’ schemes are nothing more than social welfare designed to artificially reduce (temporarily) the Live Register counts. Furthermore, DofSocial Protection has neither expertise nor experience in dealing with training. This decision further fractured the employment training and skills policy. It also created an interesting conundrum. FAS has various embedded and affiliated bodies which include participation from private sector leadership. We are now likely to find ourselves in a comical scenario where private corporate leaders will be asked to provide public service to Social Welfare. Score on decision: 0/5.
• Equality is to go into the Department of Community and Gaeltacht affairs. This, of course, is a purely optical announcement with no real meaning, other than the potential for creation of new public sector employment - 0/5.
• Mr Cowen also announced the setting up of a Public Service Board, which aims to accelerate public service reform in consultation with the unions. Amazing: after a clear show of intransigence on reforms, the unions are now formally incorporated into the process of reforms. This legislatively establishes a one-sided form of sub-Social Partnership as an official part of the State – 0/5.
• Junior minister Dara Calleary will also be assigned to push through change in the public service. Junior ministry allocation to reforming something that accounts for over 40% of our economy? For over 1/3 of our entire Exchequer Budget? Combined with the PSBoard announcement, expect no reforms of any sort to come out within the life of this Government. 0/5 folks.

Total score on the Cabinet change and new ‘reforms’ of Departments: 29/90 or 32% - a Fail even in an undergraduate course.

Per RTE report: “Announcing his changes, the Taoiseach said he was not in favour of structural changes for their own sake and said the benefits the changes bring will outweigh the costs.” Read: no costings have been made, no benefits assessment was done.

Prepare yourselves to another Government that provides policies-based evidence instead of pursuing evidence-based policies.

Economics 21/03/2010: Reckless expectations, not competition

This is a lengthy post - to reflect the importance of the issue at hand. And it is based largely on data from Professor Brian Lucey, with my added analysis.

The proposition that this post is proving is the following one:

Far from being harmed by competition from foreign lenders, Irish banking sector has suffered from its own disease of reckless lending. In fact, competition in Irish banking remains remarkably close (although below) European average and is acting as a stabilizing force in the markets relative to other factors.


I always found the argument that ‘too much competition in banking was the driver of excessive lending’ to be an economically illiterate one. Even though this view has been professed by some of my most esteemed colleagues in economics.

In theory, competition acts to lower margins in the sector, and since it takes time to build up competitive pressure, the sectors that are facing competition are characterized by stable, established players. In other words, in most cases, sectors with a lot of competition are older, mature ones. This fact is even more pronounced if entry into the sector is associated with significant capital cost requirements. Banking – in particular run of the mill, non-innovative traditional type – is the case in point everywhere in the world.

As competition drives margins down, making quick buck becomes impossible. You can’t hope to write a few high margin, high risk loans and reap huge returns. So firms in highly competitive sectors compete against each other on the basis of longer term strategies that are more stable and prudent. Deploying virtually commoditized services or products to larger numbers of population. Reputation and ever-increasing efficiencies in operations become the driving factors of every surviving firm’s success. And these promote longer term stability of the sector.

Coase’s famous proposition about transaction costs provides a basis for such a corollary.

This means that in the case of Irish banking during the last decade, if competition was indeed driving down the margins in lending (as our stockbrokers, the Government and policy analysts ardently argue today), then the following should have happened.

1. Banks should have become more prudent over time in lending and risk pricing,
2. There should have been broader diversification of the banks lending portfolia, with the bulk of new loans concentrating in the areas relating directly to depositor base – corporate and household lending, and a hefty fringe of higher-margin inter-mediation lending to financial institutions, and
3. Banks would be seeking to ‘bundle’ more services to differentiate from competitors and enhance margins.
   

In Ireland, of course, during the alleged period of ‘harmful competition’ exactly the opposite took place. Let me use Prof Brian Lucey’s data (with added analysis from myself) to show you the facts.

Firstly, Irish banks became less prudent in lending – as exemplified by falling loans approvals criteria, and by rising LTVs:

1. Lending to private sector as % of GDP was ca 50% in 1995, reaching 100% in 1998 and rising to 300% in 2009
2. Vast increases in lending to developers: in 1997 there were €10bn lent out to developers against €20bn in mortgages; in 2008 these figures were €110bn and €140bn respectively
3. Over the time when lending to private sector rose 600%, mortgages lending rose 550%, our GDP rose by 75%
   

Secondly, banks reduced their assets and liabilities diversification (charts 1-3 below) setting themselves up for a massive rise in asymmetric risk exposures.

On the funding side, out went customers deposits, in came banks deposits, foreign deposits and bonds and Irish bonds.
Capital ratios fell out of the way.

And so there has been a change in the world of Irish banking that no other competitive and mature sector of any economy has ever seen. Why? Was it because foreign banks started pushing the timid boys of BofI and AIB and Anglo and INBS out into reckless competitive lending?

You’ve gotta be mad to believe this sop. In reality, the Irish banks’ assets tell the story.

Business loans collapsed, personal loans (the stuff that allegedly, according to the likes of the Irish Times have fuelled our cars and clothing shopping binge during the Celtic Tiger years) actually declined in importance as well. Financial intermediation – the higher margin, higher risk thingy that so severely impacted the US banks – was down as well. No, competition was not driving Irish banks into the hands of higher margin lending. It was driving them into the hands of our property developers. We didn’t have a derivatives and speculative financial investment crisis here – the one that was allegedly caused by the foreign banks coming in and forcing our good boys to cut margins on run-of-the-mill ordinary lending. No, we had an old fashioned disaster of construction and property lending.

And this lending could not have been driven by foreign banks. It came from the total expansion of credit in the economy, presided over by our Central Bank and Financial Regulator, our Government and ECB.

Just how dramatic this change was? Take a look at the ratio of private sector credit to national income in the chart below.
Even a child could have seen the bust coming. The reason that our Financial Regulator and Central Bank failed to see this, despite publishing all this data in the first place, is that they were simply not looking. The former probably obsessed with the pension perks, the latter – well, may be because all the fine art in the Central Bank’s own collection was just too much of a distraction. Who knows? But judging by the above chart lack of significant correction during the crisis – we know who will pay for this in the end. Us, the taxpayers.
As chart above shows, the fundamentals for the boom – in lending and in construction – were never there, folks. And the banks missed that completely. As did our regulators and our policymakers. Brian Lucey of TCD School of Business provides evidence on what was really going on in the Irish banks (again, note that some of the analysis below is mine).
Chart above, based on the Central Bank Credit Survey, basically shows the impact three major forces: expectations of increased competition by the banks, improved banks outlook on the Irish economy three months ahead, and LTVs expectations had in Irish banks willingness to increase lending. Scores above 3 represent tightening of credit conditions (as in banks expecting to cut lending to households), while scores below 3 show forces driving looser credit to households.

If the proposition that foreign banks competition pressures drove Irish banks into looser credit supply were to be correct, one would expect the blue line above to reach far deeper into ‘below 3’ scores than the other two lines. Alas, it did not dip. In fact, competition from other banks was recognized by Irish Bankers themselves to be the least improtant factor contributing to credit supply expansion. Instead, their over-optimism about economic prospects (red line) and their willingess to give away cash at massively inlfated LTVs (the orange line – also a proxy for Bankers’ optimism regarding future direction of house prices) were the two main drivers of credit boom.

Where’s the evidence on ‘harmful competition’ that so many Central Bank leaders, the stockbrokers and Government spokespersons have decried in recent past?

The delirium of our bankers was actually so out of any proportion that, as the surveys data shows, even amidst the implosion of the housing markets since early 2008 they were still saying “hang on....we expect that changes in LTV and economic prosoects will cause us to loosen in the next 3 months". In other words, they were chasing the deflating bubble, not the imaginary foreign banks competitiors.

Let’s take another look at Brian Lucey’s data. Take the scores for Ireland in the above surveys and take their ratios to the Euro area average scores. If the ratio is in excess of 1, then the said factor has contributed to greater tightening in credit supply in Ireland than in the Euro area. If it is less than 1, then the said factor has contributed more to loosening in lending in Ireland than in the Euro area.
So, really, folks, competition in Ireland was actually more of a stabilizing force, than de-stabilizing one. LTV’s optimism and lack of realism in economic forecasts were the two main driving forces of the boom.

Lastly, ECB Herfindahl Index (ratio of Ireland to “big5” EU states) provides exactly the same conclusions:
Again, what above shows is that on virtually every occasion, Irish reading for Herfindahl Index (measuring degree of concentration in banking sector) is in excess of the average Index reading for top 5 EU countries. In other words, there was no such thing as ‘too much competition’ going on in Irish banking sector. If anything, there was somwhat too little of it, compared to Germany, France, Italy, UK and the Netherlands.

And now, for the test of all of this. The chart below regresses each survey factor on the private sector credit index. The negatively sloped line – for LTV and economic prospect factors combined - shows that when this factor scoring in the survey increased, lending became tighter. Positively sloped line – for competition – shows that when competition pressures rose (factor reading declined), lending actually got tighter. And the statistical significance of the LTV and expectations factors is more than double that of competition...
Let’s just stop talking nonesense about too much competition in Irish banking sector drove unsustainable lending. More likely – an anticiaption by our bankers that no matter what they do, they will never be allowed to fail by the state, plus an absolutely rediculous expectations about opur economy drove our banks to the brink.

Economics 18/03/2010: Services Inflation in Ireland

CSO released an interesting set of new stats on price inflation in select services. Per experimental Services Producer Price Index (SPPI) average prices charged by domestic service producers to other businesses in Quarter 4 2009, were on average 4.1% lower in the year when compared with the same period last year.

The most notable changes in the year were:

• Architecture, Engineering and Technical Testing (-9.7%),
  
• Computer Programming and Consultancy (-8.5%),
• Advertising, Media Representation and Market Research (-7.2%),
  
• Freight and Removal by Road (-5.2%) and Air Transport (+6.3%).
  

Services Prices increased by 0.4% in the quarter. This compares to a decrease of 2.3% recorded in Q3 2009.

The most significant quarterly price decreases were in

• Freight and Removal by Road (-2.2%),
  
• Postal and Courier (-1.4%) and
  
• Sea and Coastal Transport (-1.4%).
  

There was an increase of 4.8% in Air Transport.

Now, what CSO report did not show is the following. While deflation in higher value added, human capital-intensive services was rather significant, mid-range value-added services saw much more moderate deflation, with low value added labour-intensive sectors such as security services holding up almost unchanged over time. Chart below illustrates:
For all the talk about improved competitiveness, transport-related services costs are still on the upward trend:
And this is before Carbon Taxes kicked in.

Another interesting point to be made here is that the first chart above appears to suggest that deflation is almost not happening at the level of sectors that are labour intensive - industries most impacted by the minimum wage. In more wage-flexible sectors, where human capital drives value added to much higher levels, inflation is running negative. This has two implications going forward, should this trend persist:

1. Despite all the talk about the 'poor' bearing the brunt of the crisis, at least as far as prices charged for services indicate so far, there is most likely stronger deflation of wages at the higher end of wages distribution;
2. While competitiveness of our traded and higher value added services is increasing, competitiveness of our domestic services (anchored in higher labour intensities) is not improving significantly.
   

Economics 18/03/2010: A new warning to Ireland

Ireland was put on notice in the EU Commission assessment of fiscal positions going forward. per FT report today: European Commission warned eight countries, including Germany, France, Italy and Spain, Austria, Belgium, Ireland and the Netherlands that their forecasts for fiscal deficits reduction and growth for the next 4 years are basically failing to meet reasonable tests of robustness and that they need to identify exact measures they will take to meet their medium-term deficit reduction targets of 3 per cent or less of gross domestic product.

This is a second round of warnings covering Ireland's budgetary plans after earlier this month the ECB has qualified its assessment of Euro area fiscal consolidation measures with a statement, in the case of Ireland, referring to the lack of clear evidence on the ways in which the target will be achieved (see ECB Monthly Bulletin, 03/2010 page 85).

The warnings - usually a saber-rattler, and nothing more - but this time around it is a serious note. The reason is simple. It now appears that Germany is set against a direct bailout for Greece, pushing instead for joint IMF/Euro area action backed primarily by IMF. Here is the background on this:

Bloomberg reports (here) that Michael Meister, the CDU’s finance spokesman, said: “We have to think about who has the instruments to push for Greece to restore its capital-markets access... Nobody apart from the IMF has these instruments,” and that attempting a Greek rescue without the IMF “would be a very daring experiment.”

Angela Merkel told the German parliament yesterday: “The problem has to be solved from the Greek side and everything that is being considered has to be oriented in that direction.”

This clearly implies that fiscal deficits corrections will have to be pursued by countries in the environment where the markets cannot price in collective risk averaging within the Euro area, which in effect means that spreads between German and PIIGS bonds yields will have to rise and stay elevated through 2014. And this, in turn, means Ireland is now exposed to a potential sever credit crunch on the Government side.

And there is an even greater threat for Ireland, as Irish Exchequer is much more dependent on the good will of German banks than any other Exchequer in the PIIGS club (see chart below, courtesy of http://spaineconomy.blogspot.com/):
Frightening, especially since the chart is expressed in Euros, which of course puts us well ahead in proportional terms of Spain, not to mention Portugal and Greece, for all countries, except Switzerland.

Economics 17/03/2010: Nama Estimation Procedures

Yesterday I finally got a few minutes to read through the latest Government documentation on Nama - "Determination of Long-Term Economic Value of Property and Bank Assets" regulations SINo88 of 2010 from March 5 (link here). This delightfully thin document is a treat for anyone who cares to study just how inept our authorities can be when it comes to measuring and assessing/pricing risk.

Timing

Paragraph 2 page 2 defined 'relevant period' - used in assessing long-term economic value - as 'the period that began on 1 January 1985 and ended on 31 December 2005'. Per para 5.ii page 3, this period will be used to estimate reference prices for land based on land hedonic (econometric) links to demographic variables (5.b.i), interest rates (5.b.ii) and GDP (5.b.iii).

The problem here is that there is no clear identification as to which time horizon (the full 21 years worth or some sub-set thereof) the Government will use. And this is crucial, as this period largely covers steadily rising market with almost no corrections. Which means that should Nama use dynamic trend for estimating the land prices, it would be rather accurate within the sample, but will be absolutely ad hoc outside the sample (per Lucas critique).

Of course, Nama won't take dynamic pricing - and as is clear from 5.(1).(a).(i) and (ii) it is going to take 'prices' and 'yields' - i.e. point estimates. Which most likely means some sort of an average. It is important, therefore, to have an exact idea as to within what sub-period of 1985-2005 is this average going to be taken. The note does not identify this exactly, leaving the door open for Nama to deal with the data as it sees appropriate.

Discount factors

There is an added complication to the entire valuations scheme. SSNo88 states in 5.(1).(a) that a discount (adjustment) factor for land located within the State will be based on a difference in price of land on valuation date (nearly absolutely unknown to Nama) and the Long Term (economic) Value (LTEV) price (also unknown to Nama). And this means that Nama will start its valuations process by applying an unknown discount factor to a risky asset it is buying. No data listed within SSNo88 as the basis for valuations allows Nama to escape this grim reality.

Discount Rates

There are other fundamental errors built into valuations process. For example, NAMA discount rates - equivalent to interest rates - on bank assets are (as listed in 2.(2).(a)-(b) on page 2: 4.54% for 3-year rate, 5.57% for 5-year rate, and 6.16% for 8-year rate. This presents a little bit of a conundrum. Firstly, are these rates annualized compounded or simple? Second, and even more important - why are these rates chosen for these maturities? What yield curve has been used to impute these? No clarity on this whatsoever.

ECB gives only two types of average retail rates for non-financial corporations loans: as of January 2010 (the latest), we have existent loans with rate fix up to 1 year are priced at 2.96% which, factoring in Government's 1.7% risk premium margin implies a rate of 4.66%, not 4.54%. Off the starting line, there is a built in subsidy from Nama.

And this subsidy is greater than 12bps spread between the above two rates. How I know this? Well, think - can assets we are buying into Nama attract any loans in the private sector? At any valuations? No. So what justifies that 1.7% risk premium the Government applies (per 2.(2).(a)-(c)) to all loans it will be buying? And why is the risk premium independent of maturity period? Surely it should be rising with maturity?

Let's take a look at what we have from the ECB: non-financial corporate overdraft rate as of January 2010 averaged in Ireland at 5.74%. Suppose this was the basis for our Nama valuations (I still think this is too low of a rate given the assets quality and given the fact that ECB reports 'offer' rates by the banks, not the actual rates on which loans were issued, but what the hell, let's use this as a base assumption).

With Government risk premium, this should imply a 3-year discount rate of 7.44% (still shy of corporate junk bonds, but much better than 4.54% built into Nama). This rate (per 7.(a)) will cover land-backed loans where land value has fallen just 10% below its LTEV - the high quality loans in Nama books. Now, using SSNo88-implied yield curve, 5-year discount rate consistent with our assumed base rate should be 2.08% and for 8-year rate, the risk margin should be 1.9%.

This means that if Nama were to use the riskiest loans rates we have - those for overdrafts by non-financial corporate sector, and use upward sloping risk margins (to reflect the fact that the longer the duration of the rate, the lower is the quality of assets to which it applies - per SSNo88 page 5 own admission), the rates of interest imputed on Nama assets should be:

• 3-year money - at 7.44%, not Nama-assumed 4.54% (a loss to the taxpayer or a subsidy to developers and banks of 2.9% per annum);
• 5-year money - at 9.13%, not Nama-assumed 5.57% (a loss to the taxpayer or a subsidy to developers and banks of 3.56% per annum); and
• 8-year money - at 9.67%, not Nama-assumed 6.16% (a loss to the taxpayer or a subsidy to developers and banks of 3.51% per annum).

Let me give you a look at the Nama interest rate pricing generosity from another angle. Irish Exchequer is currently borrowing at 5% interest rate in the markets. This, presumably does not include Mr Lenihan's 1.7% risk margin. Which means that if Nama was buying loans from borrowers who are as credit-worthy as the Irish Exchequer, it should be applying a rate of 6.7% to these loans. My estimate of 7.44% is much closer to that than SSNo88 statutory fixed rate of 4.54%.

Proposition: under Nama, effective interest rate subsidies for defaulting loans (accruing to banks and developers) will range between 2.9% and 3.56% per annum.

Proof: see two alternative arguments above.

Estimation process

Another issue, related to interest rates arises when the SSNo88 outlines 3 sets of variables Nama will use to impute LTEV based on 'correlation' (whatever this means in econometric terms, I have no idea): 'between land prices and interest rates in the State' (5.(1).(b).(ii)). Can someone explain to me which interest rates Nama has in mind? Central Bank rates? Retail rates? Retail rates for non-financial corporations loans?

The same applies to paragraph (5.(1).(c)).

Valuations timing

The document SSNo88 was published in March 2010. Nama will not begin valuations before April and will not finish these before the end of 2010 (optimistic projections). So why are all valuations being made by Nama will take into account only market values of land prior to January 10, 2010? Surely, falling markets mean - and consensus forecast expects - at least 5%+ decline in house prices (what can one say about land!) over 2010. Is Nama going to ignore this reality and price the assets in buys in, say, November 2010 at prices valuations for January 2010?

Let me explain. In a year when I bought my house, within 11 months of my purchase, home prices fell roughly speaking 3%. Do I get to go to my bank and tell them - 'Folks, shave off 3% from my total original mortgage as Nama is doing for you?'

5% is a non-trivial number, adding up, over the loan book Nama id about to take up roughly €3.9 billion overvaluation, spread over 15 years with interest and market discounts accruing to it.

Use of GDP

SSNo88 applies to valuations of land and real estate assets. These are non-exportable. Why is then the Government planning to use the rates of growth in GDP, not GNP? Does our booming (1985-2005) pharma sector has anything to do with the fundamentals on which land prices are set? Using GDP for the estimation process instead of GNP introduces a distortion of between 12% and 18% depending on the range of years used. This distortion risks further overvaluing the LTEV for land.

Building in dreamy planning

Paragraph 5.1.d.ii states that Nama will use "existing and future transport planning and the associated supply and demand projections for land use" in its valuations of LTEV. What does this mean? Will Nama use full extent of NDP plans? Including the frozen and indefinitely postponed plans? There is significant divergence between what is planned and what is delivered. And in the next 10 or so years, this divergence will be in the direction of planned transport investment being well in excess of real investment. If Nama were to use the former as a basis for estimates, then there will be land with LTEV in excess of realizable value because its estimated LTEV will be based on excessively optimistic plans for transport investment.

At any rate - the current phrasing of the SSNo88 does not provide for a rigorous definition of what planned infrastructure will Nama actually factor in. This makes the LTEV estimation process outlined in LTEV completely undefinable under the current legislation.

Land based outside the State

The entire section 6 outlining the LTEV estimation process for land outside the State is simply a carbon copy of the valuation processes for LTEV within the State. This suggests that - given that assets being valued are different in nature (legal and economic), risk and geographies - the Minister has no idea how these different risks should be reflected in the estimation process.

The section does not even mention exchange rate risks or derivatives on Forex exposure attached to loans. There is no clear understanding as to what interest rates should apply and how to deal with the carry trades.

Operational costs

Section 8 of the note states that the assumed 'due diligence costs, incurred or likely to be incurred by Nama over its lifetime' is 0.25%. This is simply unrealistic. Industry average operating cost on performing loans - across all subheads - is equal to about 0.75-1% in times when operating conditions are deemed to be normal. As of the end of February 2010, Nama, reportedly already has blown through its entire 2010 legal budget. How can 25bps cover its due diligence cost over life time?


In short, SSNo88 is yet another document that shows just how exposed Nama remains to shoddy planning and poor estimation procedures, courtesy of the DofF that simply cannot deliver realistic and transparent operational guidelines.